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All Textbook Solutions for Fundamentals of Financial Management, Concise Edition (with Thomson ONE - Business School Edition, 1 term (6 months) Printed Access Card) (MindTap Course List)
What is a firms intrinsic value? Its current stock price? Is the stocks true long-run value more closely related to its intrinsic value or to its current price?When is a stock said to be in equilibrium? Why might a stock at any point in time not be in equilibrium?3Q4Q5Q6QShould stockholder wealth maximization be thought of as a long-term or a short-term goal? For example, if one action increases a firms stock price from a current level of 20 to 25 in 6 months and then to 30 in 5 years, but another action keeps the stock at 20 for several years but then increases it to 40 in 5 years, which action would be better? Think of some specific corporate actions that have these general tendencies.8QThe president of Southern Semiconductor Corporation (SSC) made this statement in the companys annual report SSCs primary goal is to increase the value of our common stockholders' equity. Later in the report the following announcements were made: a. The company contributed 1.5 million to the symphony orchestra in Birmingham, Alabama, its headquarters city. b. The company is spending 5500 million to open a new plant and expand operations in China. No profits will be produced by the Chinese operation for 4 years, so earnings will be depressed during this period versus what they would have been had the decision been made not to expand in China. c. The company holds about half of its assets in the form of U.S. Treasury bonds, and it keeps these funds available for use in emergencies. In the future, though, SSC plans to shift its emergency funds from Treasury bonds to common stocks. Discuss how SSCs stockholders might view each of these actions and how the actions might affect the stock price.10Q11Q12Q13QBedrock Company has 70 million in debt and 30 million in equity. The debt matures in 1 year and has a 10% interest rate, so the company is promising to pay back 77 million to its debtholders 1 year from now. The company is considering two possible investments, each of which will require an upfront cost of 100 million. Each investment will last for 1 year, and the payoff from each investment depends on the strength of the overall economy. There is a 50% chance that the economy will be weak and a 50% chance it will be strong. Here are the expected payoffs (all dollars are in millions) from the two investments: Note that the two projects have the same expected payoff, but Project H has higher risk. The debtholders always get paid first and the stockholders receive any money that is available after the debtholders have been paid. Assume that if the company doesnt have enough funds to pay off its debtholders 1 year from now, then Bedrock will declare bankruptcy. If bankruptcy is declared, the debtholders will receive all available funds, and the stockholders will receive nothing. a. Assume that the company selects Investment L. What is the expected payoff to the firms debtholders? What is the expected payoff to the firms stockholders? b. Assume that the company selects Investment H. What is the expected payoff to the firms debtholders? What is the expected payoff to the firms stockholders? c. Would the debtholders prefer that the companys managers select Project L or Project H? Briefly explain your reason. d. Explain why the companys managers, acting on behalf of the stockholders, might select Project H, even though it has greater risk. e. What actions can debtholders take to protect their interests?FINANCIAL MARKETS AND INSTITUTIONS Assume that you recently graduated with a degree in finance and have just reported to work as an investment adviser at the brokerage firm of Smyth Barry Co. Your first assignment is to explain the nature of the U.S. financial markets to Michelle Varga, a professional tennis player who recently came to the United States from Mexico. Varga is a highly ranked tennis player who expects to invest substantial amounts of money through Smyth Barry. She is very bright; therefore, she would like to understand in general terms what will happen to her money. Your boss has developed the following questions that you must use to explain the U.S. financial system to Varga. a. What are the three primary ways in which capital is transferred between savers and borrowers? Describe each one. b. What is a market? Differentiate between the following types of markets: physical asset markets versus financial asset markets, spot markets versus futures markets, money markets versus capital markets, primary markets versus secondary markets, and public markets versus private markets. c. Why are financial markets essential for a healthy economy and economic growth? d. What are derivatives? How can derivatives be used to reduce risk? Can derivatives be used to increase risk? Explain. e. Briefly describe each of the following financial institutions: investment banks, commercial banks, financial services corporations, pension funds, mutual funds, exchange traded funds, hedge funds, and private equity companies. f. What are the two leading stock markets? Describe the two basic types of stock markets. g. If Apple Computer decided to issue additional common stock, and Varga purchased 100 shares of this stock from Smyth Barry, the underwriter, would this transaction be a primary or a secondary market transaction? Would it make a difference if Varga purchased previously outstanding Apple stock in the dealer market? Explain. h. What is an initial public offering (IPO)? i. What does it mean for a market to be efficient? Explain why some stock prices may be more efficient than others. j. After your consultation with Michelle, she wants to discuss these two possible stock purchases: 1. While in the waiting room of your office, she overheard an analyst on a financial TV network say that a particular medical research company just received FDA approval for one of its products. On the basis of this hot information, Michelle wants to buy many shares of that companys stock. Assuming the stock market is highly efficient, what advice would you give her? 2. She has read a number of newspaper articles about a huge IPO being carried out by a leading technology company. She wants to purchase as many shares in the IPO as possible and would even be willing to buy the shares in the open market immediately after the issue. What advice do you have for her? How does behavioral finance explain the real-world inconsistencies of the efficient markets hypothesis (EMH)?How does a cost-efficient capital market help reduce the prices of goods and services?Describe the different ways in which capital can be transferred from suppliers of capital to those who are demanding capital.3Q4Q5Q6QDifferentiate between dealer markets and stock markets that have a physical location.8QBriefly explain what is meant by the term efficiency continuum.Explain whether the following statements are true or false. a. Derivative transactions are designed to increase risk and are used almost exclusively by speculators who are looking to capture high returns. b. Hedge funds typically have large minimum investments and are marketed to institutions and individuals with high net worths. c. Hedge funds have traditionally been highly regulated. d. The New York Stock Exchange is an example of a stock exchange that has a physical location. e. A larger bid-ask spread means that the dealer will realize a lower profit.1QWho are some of the basic users of financial statements, and how do they use them?If a typical firm reports 20 million of retained earnings on its balance sheet, could its directors declare a 20 million cash dividend without having any qualms about what they were doing? Explain your answer.Explain the following statement: Although the balance sheet can be thought of as a snapshot of a firms financial position at a point in time, the income statement reports on operations over a period of time.5Q6Q7Q8QHow are managements actions incorporated in EVA and MVA? How are EVA and MVA interconnected?Explain the following statement: Our tax rates are progressive.11QHow does the deductibility of interest and dividends by the paying corporation affect the choice of financing (i.e., the use of debt versus equity)?BALANCE SHEET The assets of Dallas Associates consist entriely of current assets and net plant and equipment. The firm has total assets of 25 million and net plant and equipment equals 2 million. It has notes payable of 150.000, long-term debt of 750,000, and total common equity of 15 million. The firm does have accounts payable and accruals on its balance sheet the firm only finances with debt and common equity, so it has no preferred stock on its balance sheet. a. What is the companys total debt? b. What is the amount of total liabilities and equity that appears on the firms balance sheet? c. What is the balance of current assets on the firms balance sheet? d. What is the balance of current liabilities on the firms balance sheet? e. What is the amount of accounts payable and accruals on its balance sheet? (Him: Consider this as a single line item on the firms balance sheet.) f. What is the firms net working capital? g. What is the firms net operating working capital? h. What is the explanation for the difference in your answers to parts f and g?INCOME STATEMENT Little Books Inc. recently reported 3 million of net income. Its EBIT was 6 million, and its tax rate was 40%. What was its interest expense? [Hint: Write out the headings for an income statement and fill in the known values. Then divide 3 million of net income by (1 T) = 0 6 to find the pretax income. The difference between EBIT and taxable income must be interest expense. Use this same procedure to complete similar problems.]INCOME STATEMENT Pearson Brothers recently reported an EBITDA of 7.5 million and net income of 1.8 million. It had 2.0 million of interest expense, and its corporate tax rate was 40%. What was its change for depreciation and amortization?STATEMENT OF STOCKHOLDERS' EQUITY In its most recent financial statements, New-house Inc. reported 50 million of net income and 810 million of retained earnings. The previous retained earnings were 780 million. How much in dividends were paid to shareholders during the year? Assume that all dividends declared were actually paid.MVA Henderson Industries has 500 million of common equity on its balance sheet; its stock price is 60 per share; and its Market Value Added (MVA) is 130 million. How many common shares are currently outstanding?MVA Over the years, McLaughlin Corporation's stockholders have provided 35,000,000 of capital, when they purchased new issues of stock and allowed management to retain some of the firm's earnings. The firm now has 2,000,000 shares of common stock out-standing, and the shares sell at a price of 30 per share. How much value has McLaughlin's management added to stockholder wealth over the years, i.e., what is McLaughlin's MVA?EVA Britton Industries has operating income for the year of 3,000,000 and a 40% tax rate. Its total invested capital is 20,000,000 and its after-tax percentage cost of capital is 8%. What is the firm's EVA?8PSTATEMENT OF STOCKHOLDERS' EQUITY Computer World Inc. paid out 22.5 million in total common dividends and reported 278.9 million of retained earnings at year-end. The prior year's retained earnings were 212.3 million. What was the net income? Assume that all dividends declared were actually paid.EVA For 2014, Everyday Electronics reported 22.5 million of sales and 18 million of operating costs (including depreciation). The company has 15 million of total invested capital. Its after-tax cost of capital is 9% and its federal-plus-state income tax rate was 35%. What was the firm's Economic Value Added (EVA), that is, how much value did management add to stockholders' wealth during 2014?11PSTATEMENT OF CASH FLOWS You have just been hired as a financial analyst for Basel Industries. Unfortunately, company headquarters (where all of the firm's records are kept) has been destroyed by fire. So, your first job will be to recreate the firm's cash flow statement for the year just ended. The firm had 100,000 in the bank at the end of the prior year and its working capital accounts except cash remained constant during the year. It earned 5 million in net income during the year but paid 750,000 in dividends to common shareholders. Throughout the year, the firm purchased 5.5 million of machinery that was needed for a new project. You have just spoken to the firm's accountants and learned that annual depreciation expense for the year is 450,000; however, the purchase price for the machinery represents additions to property, plant, and equipment before depreciation. Finally, you have determined that the only financing done by the firm was to issue long-term debt of 1 million at a 6% interest rate. What was the firm's end-of-year cash balance? Recreate the firm's cash flow statement to arrive at your answer.13PINCOME STATEMENT Hermann Industries is forecasting the following income statement: Sales 8,000,000 Operating costs excluding depreciation amortization 4,400,000 EBITDA 3,600,000 Depreciation and amortization 800,000 EBIT 2,800,000 Interest 600,000 EBT 2,200,000 Taxes (40%) 880,000 Net income 1,320,000 The CEO would like to see higher sales and a forecasted net income of 2,500,000. Assume that operating costs (excluding depredation and amortization) are 55% of sales and that depreciation and amortization and interest expenses will increase by 10%. The tax rate, which is 40%, will remain the same. (Note that while the tax rate remains constant, the taxes paid will change.) What level of sales would generate 2,500,000 in net income?FINANCIAL STATEMENTS The Davidson Corporation's balance sheet and income statement are provided here. Davidson Corporation: Balance Sheet as of December 31, 2014 (Millions of Dollars) Assets Liabilities and Equity Cash and equivalents 15 Accounts payable 120 Accounts receivable 515 Accruals 280 Inventories 880 Notes payable 220 Total current assets 1,410 Total current liabilities 620 Net plant and equipment 2,590 Long term bonds 1,520 Total liabilities 2,140 Common stock (100 million shares) 260 Retained earrings 1,600 _ Common equity 1,860 Total assets 4,000 Total liabilities and equity 4,000 Davidson Corporation: Income Statement for Year Ending December 31, 2014 (Millions of Dollars) Sales 6,250 Operating costs excluding depreciation and amortization 5,230 EBTTDA 1,020 Depreciation amortization 220 EBIT 800 Interest 180 EBT 620 Taxes (40%) 248 Net income 372 Common dividends paid 146 Earnings per share 3.72 a. Construct the statement of stockholders' equity for December 31, 2014. No common stock was issued during 2014. b. How much money has been reinvested in the firm over the years? c. At the present time, how large a check could be written without it bouncing? d. How much money must be paid to current creditors within the next year?FREE CASH FLOW Financial information for Powell Panther Corporation is shown here. Powell Panther Corporation: Income Statements for Year Ending December 31 (Millions of Dollars) 2014 2013 Sales 1,200.0 1,000.0 Operating costs excluding depreciation and amortization 1,0200 850.0 EBITDA 180.0 150.0 Depreciation amortization 30.0 25.0 Earnings before interest and taxes (EBIT) 150.0 125.0 Interest 21.7 20.2 Earnings before taxes (EBT) 128.3 104.8 Taxes (40%) 51.3 41.9 Net income 77.0 62.9 Common dividends 60.5 . 46.4 Powell Panther Corporation: Balance Sheets as of December 31 (Millions of Dollars) 2014 2013 Assets Cash and equivalents 12.0 10.0 Accounts receivable 180.0 150.0 Inventories 180.0 200.0 Total current assets 372.0 360.0 Net plant and equipment 300.0 250.0 Total assets 672.0 610.0 Powell Panther Corporation: Balance Sheets as of December 31 (Millions of Dollars) 2014 2013 Liabilities and Equity Accounts payable 108.0 90.0 Accruals 72.0 60.0 Notes payable 67.0 51.5 Total current liabilities 247.0 201.5 Long term bonds 150.0 150.0 Total liabilities 397.0 351.5 Common stock (50 million shares) 50.0 50.0 Retained earnings 225.0 208.5 Common equity 275.0 258.5 Total liabilities and equity 672.0 610.0 a. What was net operating working capital for 2013 and 2014? b. What was the 2014 free cash flow? c. How would you explain the large increase in 2014 dividends?FINANCIAL STATEMENTS, CASH FLOW, AND TAXES Laiho Industries' 2013 and 2014 balance sheets (in thousands of dollars) are shown. 2014 2013 Cash 102,850 89,725 Accounts receivable 103,365 85,527 Inventories 38,444 34,982 Total current assets 244,659 210,234 Net fixed assets 67,165 42,436 Total assets 311,824 252,670 Accounts payable 30,761 23,109 Accruals 30,477 22.656 Notes payable 16,717 14,217 Total current liabilities 77,955 59,982 long term debt 76,264 63,914 Total liabilities 154,219 123,896 Common stock 100,000 90,000 Retained earnings 57,605 38,774 Total common equity 157,605 128,774 Total liabilities and equity 311,824 252,670 a. Sales for 2014 were 455,150,000, and EBITDA was 15% of sales. Furthermore, depreciation and amortization were 11% of net fixed assets, interest was 8,575,000, the corporate tax rate was 40%, and Laiho pays 40% of its net income as dividends. Given this information, construct the firm's 2014 income statement. b. Construct the statement of stockholders' equity for the year ending December 31,2014, and the 2014 statement of cash flows. c. Calculate 2013 and 2014 net operating working capital (NOWC) and 2014 free cash flow (FCF). d. If Laiho increased its dividend payout ratio, what effect would this have on corporate taxes paid? What effect would this have on taxes paid by the company's shareholders? e. Assume that the firm's after-tax cost of capital is 105%. What is the firm's 2014 EVA? f. Assume that the firm's stock price is 22 per share and that at year-end 2014 the firm has 10 million shares outstanding. What is the firm's MVA at year-end 2014?18ICLooking at the most recent year available, what is the amount of total assets on Starbucks' balance sheet? What percentage is fixed assets, such as plant and equipment? What percentage is current assets? How much has the company grown over the years that are shown?2DQ3DQ4DQ5DQFinancial ratio analysis is conducted by three main groups of analysts: credit analysts, stock analysts, and managers. What is the primary emphasis of each group, and how would that emphasis affect the ratios on which they focus?2QOver the past year, M.D. Ryngaert Co. had an increase in its current ratio and a decline in its total assets turnover ratio. However, the companys sales, cash and equivalents, DSO, and fixed assets turnover ratio remained constant. What balance sheet accounts must have changed to produce the indicated changes?Profit margins and turnover ratios vary from one industry to another. What differences would you expect to find between the turnover ratios, profit margins, and DuPont equations for a grocery chain and a steel company?How does inflation distort ratio analysis comparisons for one company over time (trend analysis) and for different companies that are being compared? Are only balance sheet items or both balance sheet and income statement items affected?6QGive some examples that illustrate how (a) seasonal factors and (b) different growth rates might distort a comparative ratio analysis. How might these problems be alleviated?Why is it sometimes misleading to compare a company's financial ratios with those of other firms that operate in the same industry?Suppose you were comparing a discount merchandiser with a high-end merchandiser. Suppose further that both companies had identical ROEs. If you applied the DuPont equation to both firms, would you expect the three components to be the same? for each company? If not, explain what balance sheet and income statement items might lead to the component differences.10QDifferentiate between ROE and ROIC.Indicate the effects of the transactions listed in the following table on total current assets, current ratio, and net income. Use (+) to indicate an increase, () to indicate a decrease, and (0) to indicate either no effect or an indeterminate effect Be prepared to state any necessary assumptions and assume an initial current ratio of more than 1.0. (Note: A good accounting background is necessary to answer some of these questions; if yours is not strong, answer the questions you can.)DAYS SALES OUTSTANDING Baker Brothers has a DSO of 40 days, and its annual sales are 7,300,000. What is its accounts receivable balance? Assume that it uses a 365-day year.DEBT TO CAPITAL RATIO Bartley Barstools has a market/book ratio equal to 1. Its stock price is 14 per share and it has 5 million shares outstanding. The firms total capital is 125 million and it finances with only debt and common equity. What is its debt-to-capital ratio?DuPONT ANALYSIS Doublewide Dealers has an ROA of 10%, a 2% profit margin, and an ROE of 15%. What is its total assets turnover? What is its equity multiplier?MARKET/BOOK RATIO Jaster Jets has 10 billion in total assets. Its balance sheet shows 1 billion in current liabilities, 3 billion in long-term debt, and 6 billion in common equity. It has 800 million shares of common stock outstanding, and its stock price is 32 per share. What is Jasters market/book ratio?PRICE/EARNINGS RATIO A company has an EPS of 2.00, a book value per share of 20, and a market/book ratio of 1.2x. What is its P/E ratio?DuPONT AND ROE A firm has a profit margin of 2% and an equity multiplier of 2.0. Its sales are 100 million, and it has total assets of 50 million. What is its ROE?ROE AND ROIC Hilyard Industries net income is 25,000, its interest expense is 5,000, and its tax rate is 40%. Its notes payable equals 25,000, long-term debt equals 75,000, and common equity equals 250,000. The firm finances with only debt and common equity, so it has no preferred stock. What arc the firms ROE and ROIC?DuPONT AND NET INCOME Ebersoll Mining has 6 million in sales, its ROE is 12%, and its total assets turnover is 3.2x. Common equity on the firms balance sheet is 50% of its total assets. What is its net income?BEP, ROE, AND ROIC Duval Manufacturing recently reported the following information: Net income 600,000 ROA 8% Interest expense 225,000 Accounts payable and accruals 1,000,000 Duvals tax rate is 35%. Duval finances with only debt and common equity, so it has no preferred stock. 40% of its total invested capital is debt, while 60% of its total invested capital is common equity. Calculate its basic earning power (BEP), its return on equity (ROE), and its return on invested capital (ROIC).10PRATIO CALCULATIONS Assume the following relationships for the Brauer Corp.: Sales/Total assets 1.5x Return on assets (ROA) 3.0% Return on equity (ROE) 5.0% Calculate Brauers profit margin and debt-to-capital ratio assuming the firm uses only debt and common equity, so total assets equal total invested capital.12PTIE AND ROIC RATIOS The H.R. Pickett Corp. has 500,000 of interest-bearing debt out-standing, and it pays an annual interest rate of 10%. In addition, it has 700,000 of common stock on its balance sheet. It finances with only debt and common equity, so it has no preferred stock. Its annual sales are 2 million, its average tax rate is 30%, and its profit margin is 5%. What are its TIE ratio and its return on invested capital (ROIC)?RETURN ON EQUITY Midwest Packagings ROH last year was only 3%; but its management has developed a new operating plan that calls for a debt-to-capital ratio of 60%, which will result in annual interest charges of 300,000. The firm has no plans to use preferred stock and total assets equal total invested capital. Management projects an EBIT of 1,000,000 on sales of 10,000,000, and it expects to have a total assets turnover ratio of 2.0. Under these conditions, the tax rate will be 34%. If the changes are made, what will be the companys return on equity?RETURN ON EQUITY AND QUICK RATIO Lloyd Inc. has sales of 200,000, a net income of 15,000, and the following balance sheet: The new owner thinks that inventories are excessive and can be lowered to the point where the current ratio is equal to the industry average, 25, without affecting sales or net income. If inventories are sold and not replaced (thus reducing the current ratio to 25); if the funds generated are used to reduce common equity (stock can be repurchased at book value); and if no other changes occur, by how much will the ROE change? What will be the firms new quick ratio?16PCONCEPTUAL: RETURN ON EQUITY Which of the following statements is most correct? (Hint: Work Problem 4-16 before answering 4-17, and consider the solution setup for 4-16 as you think about 4-17.) a. If a firms expected basic earning power (BEP) is constant for all of its assets and exceeds the interest rate on its debt, adding assets and financing them with debt will raise the firms expected return on common equity (ROE). b. The higher a firms tax rate, the lower its BEP ratio, other things held constant. c. The higher the interest rate on a firms debt, the lower its BEP ratio, other things held constant. d. The higher a firms debt ratio, the lower its BEP ratio, other things held constant. e. Statement a is false; but statements b, c, and d are true.TIE RATIO AEI Incorporated has 5 billion in assets, and its tax rate is 40%. Its basic earning power (BEP) ratio is 10%, and its return on assets (ROA) is 5%. What is AEIs times-interest-earned (TIE) ratio?CURRENT RATIO The Petry Company has 1312,500 in current assets and 525,000 in current liabilities. Its initial inventory level is 375,000, and it will raise funds as additional notes payable and use them to increase inventory. How much can its short-term debt (notes payable) increase without pushing its current ratio below 2.0?DSO AND ACCOUNTS RECEIVABLE Harrelson Inc. currently has 750,000 in accounts receivable, and its days sales outstanding (DSO) is 55 days. It wants to reduce its DSO to 35 days by pressuring more of its customers to pay their bills on time. If this policy adopted, the companys average sales will fall by 15%. What will be the level of accounts receivable following the change? Assume a 365-day year.P/E AND STOCK PRICE Fontaine Inc. recently reported net income of 2 million. It has 500,000 shares of common stock, which currently trades at 40 a share. Fontaine continues to expand and anticipates that 1 year from now, its net income will be 3.25 million. Over the next year, it also anticipates issuing an additional 150,000 shares of stock so that 1 year from now it will have 650,000 shares of common stock. Assuming Fontaines price/earnings ratio remains at its current level, what will be its stock price 1 year from now?22PRATIO ANALYSIS Data for Barry Computer Co. and its industry averages follow. a. Calculate the indicated ratios for Barry. b. Construct the DuPont equation for both Barry and the industry. c. Outline Barrys strengths and weaknesses as revealed by your analysis. d. Suppose Barry had doubled its sales as well as its inventories, accounts receivable, and common equity during 2014. How would that information affect the validity of your ratio analysis? (Hint: Think about averages and the effects of rapid growth on ratios if averages are not used. No calculations are needed.) Barry Computer Company: Balance Sheet as of December 31, 2014 (in Thousands) Cash 77,500 Accounts payable 129,000 Receivables 336,000 Other current liabilities 117,000 Inventories 241,500 Notes payable to bank 84,000 Total current assets 655,000 Total current liabilities 330,000 Long-term debt 256,500 Net fixed assets 292,500 Common equity 361,000 Total assets 947,500 Total liabilities and equity 947,500 Barry Computer Company: Income Statement for Year Ended December 31, 2014 (in Thousands) Sales 1,607,500 Cost of goods sold Materials 717,000 Labor 453,000 Heat, light, and power 68,000 Indirect labor 113,000 Depredation 41,500 1,392,500 Gross profit 215,000 Selling expenses 115,000 General and administrative expenses 30,00 Earnings before interest and taxes (EBIT) 70,000 Interest expense 24,500 Earnings before taxes (EBT) 45,500 Federal and state income taxes (40%) 18,200 Net income 27,300 Ratio Barry Industry Average Current ___ 2.0x Quick ___ 1.3x Days sales outstandinga ___ 35 days Inventory turnover ___ 6.7x Total assets turnover ___ 3.0x Profit margin ___ 12% aCalculation is based on a 365 day year. Ratio Barry Industry Average ROA ___ 3.6% ROE ___ 9.0% ROIC ___ 7.5% TIE ___ 3.0x Debt/Total capital ___ 47.0%DUPONT ANALYSIS A firm has been experiencing low profitability in recent years Perform an analysis of the firms financial position using the DuPont equation. The firm has no lease payments but has a 2 million sinking fund payment on its debt The most recent industry average ratios and the firms financial statements are as follows: Industry Average Ratios Current ratio 3x Fixed assets turnover 6x Debt to capital ratio 20% Total assets turnover 3x Times interest earned 7x Profit margin 3% EBITDA coverage 9x Return on total assets 9% Inventory turnover 10x Return on common equity 12.86% Days sales outstandinga 24 days Return on invested capital 11.50% aCalculation is based on a 365 day year. Balance Sheet as of December 31, 2014 (Millions of Dollars) Cash and equivalents 78 Accounts payable 45 Accounts receivable 66 Other current liabilities 11 Inventories 159 Notes payable 29 Total current assets 303 Total current liabilities 85 Long term debt 50 Tout liabilities 135 Gross fixed assets 225 Common stock 114 Less depreciation 78 Retained earnings 201 Net fixed assets 147 Total stockholders equity 315 Total assets 450 Total liabilities and equity 450 Income Statement for Year Ended December 31, 2014 (Millions of Dollars) Net sales 795.0 Cost of goods sold 660.0 Gross profit 135.0 Selling expenses 735 EBITDA 61.5 Depreciation expense 12.0 Earnings before interest and taxes (EBIT) 49.5 Interest expense 45 Earnings before taxes (EBT) 45.0 Taxes (40%) 18.0 Net income 27.0 a. Calculate the ratios you think would be useful in this analysis. b. Construct a DuPont equation and compare the company's ratios to the industry average ratios. c. Do the balance sheet accounts or the income statement figures seem to be primarily responsible for the low profits? d. Which specific accounts seem to be most out of line relative to other firms in the industry? e. If the firm had a pronounced seasonal sales pattern or if it grew rapidly during the year, how might that affect the validity of your ratio analysis? How might you correct for such potential problems?25SP26IC1DQ2DQConstruct a DuPont analysis for Hewlett Packard and its peers. What are Hewlett Packards strengths and weaknesses compared to those of its competitors?1QExplain whether the following statement is true or false: 100 a year for 10 years is an annuity; but 5100 in Year 1, 200 in Year 2, and 400 in Years 3 through 10 does not constitute an annuity. However, the second series contains an annuity.If a firms earnings per share grew from 1 to 2 over a 10-year period, the total growth would be 100%, but the annual growth rate would be less than 10%. True or false? Explain. (Hint: If you arent sure, plug in some numbers and check it out.)Would you rather have a savings account that pays 5% interest compounded semiannually or one that pays 5% interest compounded daily? Explain.5Q6QBanks and other lenders are required to disclose a rate called the APR. What is this rate? Why did Congress require that it be disclosed? Is it the same as the effective annual rate? If you were comparing the costs of loans from different lenders, could you use their APRs to determine the loan with the lowest effective interest rate? Explain.8Q1P2PFINDING THE REQUIRED INTEREST RATE Your parents will retire in 18 years. They currently have 250,000 saved, and they think they will need 1,000,000 at retirement. What annual interest rate must they earn to reach their goal, assuming they dont save any additional funds?TIME FOR A LUMP SUM TO DOUBLE If you deposit money today in an account that pays 6.5% annual interest how long will it take to double your money?TIME TO REACH A FINANCIAL GOAL You have 42,180.53 in a brokerage account, and you plan to deposit an additional 5,000 at the end of every future year until your account totals 250,000. You expect to earn 12% annually on the account. How many years will it take to reach your goal?6P7PLOAN AMORTIZATION AND EAR You want to buy a car. and a local bank will lend you 20,000. The loan will be fully amortized over 5 years (60 months), and the nominal interest rate will be 12% with interest paid monthly. What will be the monthly loan payment? What will be the loans EAR?9P10PGROWTH RATES Shalit Corporations 2013 sales were 12 million. Its 2008 sales were 6 million. a. At what rate have sales been growing? b. Suppose someone made this statement: Sales doubled in 5 years. This represents a growth of 100% in 5 years; so dividing 100% by 5, we find the growth rate to be 20% per year. Is the statement correct?EFFECTIVE RATE OF INTEREST Find the interest rates earned on each of the following: a. You borrow 700 and promise to pay back 749 at the end of 1 year. b. You lend 700 and the borrower promises to pay you 749 at the end of 1 year. c. You borrow 85,000 and promise to pay back 201,229 at the end of 10 years. d. You borrow 9,000 and promise to make payments of 2,684.80 at the end of each year for 5 years.13P14P15P16PEFFECTIVE INTEREST RATE You borrow 85,000; the annual loan payments are 8,273.59 for 30 years. What interest rate arc you being charged?18PFUTURE VALUE OF AN ANNUITY Your client is 40 years old. She wants to begin saving for retirement with the first payment to come one year from now. She can save 5,000 per year, and you advise her to invest it in the stock market, which you expect to provide an average return of 9% in the future. a. If she follows your advice, how much money will she have at 65? b. How much will she have at 70? c. She expects to live for 20 years if she retires at 65 and for 15 years if she retires at 70. If her investments continue to cam the same rate, how much will she be able to withdraw at the end of each year after retirement at each retirement age?PV OF A CASH FLOW STREAM A rookie quarterback is negotiating his first NFL contract. His opportunity cost is 10%. He has been offered three possible 4-year contracts. Payments are guaranteed, and they would be made at the end of each year. Terms of each contract are as follows: As his adviser, which contract would you recommend that he accept?21PLOAN AMORTIZATION Jan sold her house on December 31 and took a 10,000 mortgage as part of the payment. The 10-year mortgage has a 10% nominal interest rate, but it calls for semiannual payments beginning next June 30. Next year Jan must report on Schedule B of her IRS Form 1040 the amount of interest that was included in the two payments she received during the year. a. What is the dollar amount of each payment Jan receives? b. How much interest was included in the first payment? How much repayment of principal was included? How do these values change for the second payment? c. How much interest must Jan report on Schedule B for the first year? Will her interest income be the same next year? d. If the payments are constant why does the amount of interest income change over time?23P24P25PPV AND LOAN ELIGIBILITY You have saved 4,000 for a down payment on a new car. The largest monthly payment you can afford is 350. The loan will have a 12% APR based on end-of-month payments. What is the most expensive car you can afford if you finance it for 48 months? For 60 months?EFFECTIVE VERSUS NOMINAL INTEREST RATES Bank A pays 4% interest compounded annually on deposits, while Bank B pays 35% compounded daily. a. Based on the EAR (or EFF%), which hank should you use? b. Could your choice of banks be influenced by the fact that you might want to withdraw your funds during the year as opposed to at the end of the year? Assume that your funds must be left on deposit during an entire compounding period in order to receive any interest.NOMINAL INTEREST RATE AND EXTENDING CREDIT As a jewelry store manager, you want to offer credit, with interest on outstanding balances paid monthly. To carry receivables, you must borrow funds from your bank at a nominal 6%, monthly compounding. To offset your overhead, you want to charge your customers an EAR (or EFF%) that is 2% more than the bank is charging you. What APR rate should you charge your customers?BUILDING CREDIT COST INTO PRICES Your firm sells for cash only, but it is thinking of offering credit, allowing customers 90 days to pay. Customers understand the time value of money, so they would all wait and pay on the 90th day. To carry these receivables, you would have to borrow funds from your bank at a nominal 12%, daily compounding based on a 360-day year. You want to increase your base prices by exactly enough to offset your bank interest cost. To the closest whole percentage point, by how much should you raise your product prices?30PREQUIRED LUMP SUM PAYMENT Starting next year, you will need 10,000 annually for 4 years to complete your education. (One year from today you will withdraw the first 10,000.) Your unde deposits an amount today in a bank paying 5% annual interest, which will provide the needed 10,000 payments. a. How large must the deposit be? b. How much will be in the account immediately after you make the first withdrawal?REACHING A FINANCIAL GOAL Six years from today you need 10,000. You plan to deposit 1,500 annually, with the first payment to be made a year from today, in an account that pays an 8% effective annual rate. Your last deposit, which will occur at the end of Year 6, will be for less than 1,500 if less is needed to reach 10,000. How large will your last payment be?FV OF UNEVEN CASH FLOW You want to buy a house within 3 years, and you are currently saving for the down payment. You plan to save 5,000 at the end of the first year, and you anticipate that your annual savings will increase by 10% annually thereafter. Your expected annual return is 7%. How much will you have for a down payment at the end of Year 3?AMORTIZATION SCHEDULE a. Set up an amortization schedule for a 25,000 loan to be repaid in equal installments at the end of each of the next 3 years. The interest rate is 10% compounded annually. b. What percentage of the payment represents interest and what percentage represents principal for each of the 3 years? Why do these percentages change over time?35P36P37P38P39PREQUIRED ANNUITY PAYMENTS A father is now planning a saving program to put his daughter through college. She is 13, plans to enroll at the university in 5 years, and should graduate 4 years later. Currently, the annual cost (for everythingfood, clothing, tuition, books, transportation, and so forth) is 15,000, but these costs are expected to increase by 5% annually. The college requires total payment at the start of the year. She now has 7,500 in a college savings account that pays 6% annually. Her father will make six equal annual deposits into her account; the first deposit today and the sixth on the day she starts college. How large must each of the six payments be? [Hint: Calculate the cost (inflated at 5%) for each year of college and find the total present value of those costs, discounted at 6%, as of the day she enters college. Then find the compounded value of her initial 7,500 on that same day. The difference between the PV of costs and the amount that would be in the savings account must be made up by the fathers deposits, so find the six equal payments that will compound to the required amount.]41SP42ICSuppose interest rates on residential mortgages of equal risk are 5.5% in California and 7.0% in New York. Could this differential persist? What forces might tend to equalize rates? Would differentials in borrowing costs for businesses of equal risk located in California and New York be more or less likely to exist than differentials in residential mortgage rates? Would differentials in the cost of money for New York and California firms be more likely to exist if the firms being compared were very large or if they were very small? What are the implications of all of this with respect to nationwide branching?Which fluctuate morelong-term or short-term interest rates? Why?Suppose you believe that the economy is just entering a recession. Your firm must raise capital immediately, and debt will be used. Should you borrow on a long-term or a short-term basis? Why?4QSuppose a new process was developed that could be used to make oil out of seawater. The equipment required is quite expensive; but it would in time lead to low prices for gasoline, electricity, and other types of energy. What effect would this have on interest rates?6Q7QSuppose interest rates on Treasury bonds rose from 5% to 9% as a result of higher interest rates in Europe. What effect would this have on the price of an average companys common stock?9QSuppose you have noticed that the slope of the corporate yield curve has become steeper over the past few months. What factors might explain the change in the slope?1PREAL RISK-FREE RATE You read in The Wall Street Journal that 30-day T-bills are currently yielding 5.5%. Your brother-in-law, a broker at Safe and Sound Securities, has given you the following estimates of current interest rate premiums: Inflation prcmium= 3.25% Liquidity premium =0.6% Maturity risk premium = 1.8% Default risk premium = 2.15% On the basis of these data, what is the real risk free rote cf return?3PDEFAULT RISK PREMIUM A Treasury bond that matures in 10 years has a yield of 6%. A 10-year corporate bond has a yield of 8%. Assume that the liquidity premium on the corporate bond is 0.5%. What is the default risk premium on the corporate bond?5P6P7P8P9PINFLATION Due to a recession, expected inflation this year is only 3%. However, the inflation rate in Year 2 and thereafter is expected to be constant at some level above 3%. Assume that the expectations theory holds and the real risk-free rate (r) is 2%. If the yield on 3-year Treasury bonds equals the 1-year yield plus 2%, what inflation rate is expected after Year 1?11P12P13P14P15P16PINTEREST RATE PREMIUMS A 5-year Treasury bond has a 5.2% yield. A 10-year Treasury bond yields 6.4%, and a 10-year corporate bond yields 8.4%. The market expects that inflation will average 2.5% over the next 10 years (IP10 = 2.5%). Assume that there is no maturity risk premium (MRP = 0) and that the annual real risk-free rate, r, will remain constant over the next 10 years. (Hint: Remember that the default risk premium and the liquidity premium are zero for Treasury securities: DRP = LP = 0.) A 5-year corporate bond has the same default risk premium and liquidity premium as the 10-year corporate bond described. What is the yield on this 5-year corporate bond?18P19PINTEREST RATE DETERMINATION AND YIELD CURVES a. What effect would each of the following events likely have on the level of nominal interest rates? 1. Households dramatically increase their savings rate. 2. Corporations increase their demand for funds following an increase in investment opportunities. 3. The government runs a larger-than-expected budget deficit. 4. There is an increase in expected inflation. b. Suppose you are considering two possible investment opportunities: a 12-year Treasury bond and a 7-year, A-rated corporate bond. The current real risk-free rate is 4%; and inflation is expected to be 2% for the next 2 years, 3% for the following 4 years, and 4% thereafter. The maturity risk premium is estimated by this formula: MRP = 0 02(t 1)%. The liquidity premium (LP) for the corporate bond is estimated to be 0.3%. You may determine the default risk premium (DRP), given the companys bond rating, from the table below. Remember to subtract the bonds LP from the corporate spread given in the table to arrive at the bonds DRP. What yield would you predict for each of these two investments? Rate Corporate Bond Yield Spread = DRP + LP U.S. Treasury 0.83% ---- AAA corporate 0.93 0.10% AA corporate 1.29 0.46 A corporate 1.67 0.84 c. Given the following Treasury bond yield information, construct a graph of the yield curve. Maturity Yield 1 year 5.37% 2 years 5.47 3 years 5.65 4 years 5.71 5 years 5.64 10 years 5.75 20 years 6.33 30 years 5.94 d. Based on the information about the corporate bond provided in part b, calculate yields and then construct a new yield curve graph that shows both the Treasury and the corporate bonds. e. Which part of the yield curve (the left side or right side) is likely to be most volatile over time? f. Using the Treasury yield information in part c, calculate the following rates using geometric averages: 1. The 1-year rate 1 year from now 2. The 5-year rate 5 years from now 3. The 10-year rate 10 years from now 4. The 10-year rate 20 years from nowINTEREST RATE DETERMINATION Maria Juarez is a professional tennis player, and your firm manages her money. She has asked you to give her information about what determines the level of various interest rates. Your boss has prepared some questions for you to consider. a. What are the four most fundamental factors that affect the cost of money, or the general level of interest rates, in the economy? b. What is the real risk-free rate of interest (r) and the nominal risk-free rate (rRF)? How are these two rates measured? c. Define the terms inflation premium (IP), default risk premium (DRP), liquidity premium (LP), and maturity risk premium (MRP). Which of these premiums is included in determining the interest rate on (1) short-term U.S. Treasury securities, (2) long-term U.S. Treasury securities, (3) short-term corporate securities, and (4) long-term corporate securities? Explain how the premiums would vary over time and among the different securities listed. d. What is the term structure of interest rates? What is a yield curve? e. Suppose most investors expect the inflation rate to be 5% next year, 6% the following year, and 8% thereafter. The real risk-free rate is 3%. The maturity risk premium is zero for bonds that mature in 1 year or less and 0.1% for 2-year bonds; then the MRP increases by 0.1% per year thereafter for 20 years, after which it is stable. What is the interest rate on 1-, 10-, and 20-year Treasury bonds? Draw a yield curve with these data. What factors can explain why this constructed yield curve is upward sloping? f. At any given time, how would the yield curve facing a AAA-rated company compare with the yield curve for U.S. Treasury securities? At any given time, how would the yield curve facing a BB-rated company compare with the yield curve for U.S. Treasury securities? Draw a graph to illustrate your answer. g. What is the pure expectations theory? What does the pure expectations theory imply about the term structure of interest rates? h. Suppose you observe the following term structure for Treasury securities: Maturity Yield 1 year 6.0% 2 years 6.2 3 years 6.4 4 years 6.5 5 years 6.5 Assume that the pure expectations theory of the term structure is correct. (This implies that you can use the yield curve provided to back out the markets expectations about future interest rates.) What does the market expect will be the interest rate on 1-year securities 1 year from now? What does the market expect will be the interest rate on 3-year securities 2 years from now? Calculate these yields using geometric averages. i. Describe how macroeconomic factors affect the level of interest rates. How do these factors explain why interest rates have been lower in recent years?A sinking fund can be set up in one of two ways: The corporation makes annual payments to the trustee, who invests the proceeds in securities (frequently government bonds) and uses the accumulated total to retire the bond issue at maturity. The trustee uses the annual payments to retire a portion of the issue each year, calling a given percentage of the issue by a lottery and paying a specified price per bond or buying bonds on the open market, whichever is cheaper. What are the advantages and disadvantages of each procedure from the viewpoint of the firm and the bondholders?Can the following equation be used to find the value of a bond with N years to maturity that pays interest once a year? Assume that the bond was issued several years ago. V6=t=1NAnnualinterest(1+rd)t+Parvalue(1+rd)NThe values of outstanding bonds change whenever the going rate of interest changes. In general, short-term interest rates are more volatile than long-term interest rates. Therefore, short-term bond prices are more sensitive to interest rate changes than are long-term bond prices. Is that statement true or false? Explain. (Hint: Make up a reasonable example based on a 1-year and a 20-year bond to help answer the question.)If interest rates rise after a bond issue, what will happen to the bonds price and YTM? Does the time to maturity affect the extent to which interest rate changes affect the bonds price? (Again, an example might help you answer this question.)Discuss the following statement: A bonds yield to maturity is the bonds promised rate of return, which equals its expected rate of return.If you buy a callable bond and interest rates decline, will the value of your bond rise by as much as it would have risen if the bond had not been callable? Explain.Assume that you have a short investment horizon (less than 1 year). You are considering two investments: a 1-year Treasury security and a 20-year Treasury security. Which of the two investments would you view as being riskier? Explain.Indicate whether each of the following actions will increase or decrease a bonds yield to maturity: a. The bonds price increases. b. The bond is downgraded by the rating agencies. c. A change in the bankruptcy code makes it more difficult for bondholders to receive payments in the event the firm declares bankruptcy. d. The economy seems to be shifting from a boom to a recession. Discuss the effects of the firms credit strength in your answer. e. Investors learn that the bonds are subordinated to another debt issue. f.Why is a call provision advantageous to a bond issuer? When would the issuer be likely to initiate a refunding call?10Q11Q12Q13Q14QA bonds expected return is sometimes estimated by its YTM and sometimes by its YTC. Under what conditions would the YTM provide a better estimate, and when would the YTC be better?1PYIELD TO MATURITY AND FUTURE PRICE A bond has a 1,000 par value, 10 years to maturity, and a 7% annual coupon and sells for 985. a. What Is its yield to maturity (YTM)? b. Assume that the yield to maturity remains constant for the next 3 years. What will the price be 3 years from today?BOND VALUATION Nungesser Corporation's outstanding bonds have a 1,000 par value, a 9% semiannual coupon, 8 years to maturity, and an 8.5% YTM. What is the bond's price?YIELD TO MATURITY A firms bonds have a maturity of 10 years with a 51,000 face value, have an 8% semiannual coupon, are callable in 5 years at 1,050, and currently sell at a price of 1,100. What are their nominal yield to maturity and their nominal yield to call? What return should investors expect to earn on these bonds?5PBOND VALUATION An investor has two bonds in her portfolio. Bond C and Bond Z. Each bond matures in 4 years, has a face value of 1,000, and has a yield to maturity of 9 6%. Bond C pays a 10% annual coupon, while Bond Z is a zero coupon bond. a. Assuming that the yield to maturity of each bond remains at 9.6% over the next 4 years, calculate the price of the bonds at each of the following years to maturity: Years to Maturity Price of Bond C Price of Bond Z 4 ___________ ___________ 3 ___________ ___________ 2 ___________ ___________ 1 ___________ ___________ 0 ___________ ____________ b. Plot the time path of prices for each bond.INTEREST RATE SENSITIVITY .An investor purchased the following 5 bonds. Each bond had a par value of 1,000 and an 8% yield to maturity on the purchase day. Immediately after the investor purchased them, interest rates fell, and each then had a new YTM of 7% What is the percentage change in price for each bond after the decline in interest rates? Fill in the following table:8PYIELD TO MATURITY Heymann Company bonds have 4 years left to maturity. Interest is paid annually, and the bonds have a 1,000 par value and a coupon rate of 9%. a. What is the yield to maturity at a current market price of (1) 829 and (2) 1,104? b. Would you pay 829 for each bond if you thought that a "fair" market interest rate for such bonds was 12%that is, if rd = 12%? Explain your answer.CURRENT YIELD, CAPITAL GAINS YIELD, AND YIELD TO MATURITY Hooper Printing Inc. has bonds outstanding with 9 years left to maturity. The bonds have an 8% annual coupon rate and were issued 1 year ago at their par value of 1,000. However, due to changes in interest rates, the bond's market price has fallen to 901.40. The capital gains yield last year was 9 86%. a. What is the yield to maturity? b. For the coming year, what are the expected current and capital gains yields? (Hint: Refer to Footnote 7 for the definition of the current yield and to Table 7.1.) c. Will the actual realized yields be equal to the expected yields if interest rates change? If not, how will they differ?BOND YIELDS Last year Clark Company issued a 10-year, 12% semiannual coupon bond at its par value of 1,000. Currently, the bond can be called in 4 years at a price of 1,060 and it sells for 1,100. a. What arc the bonds nominal yield to maturity and its nominal yield to call? Would an investor be more likely to earn the YTM or the YTC? b. What is the current yield? Is this yield affected by whether the bond is likely to be called? (Hint: Refer to Footnote 7 for the definition of the current yield and to Table 7.1.) c. What is the expected capital gains (or loss) yield for the coming year? Is this yield dependent on whether the bond is expected to be called? Explain your answer.YIELD TO CALL It is now January 1, 2014, and you are considering the purchase of an outstanding bond that was issued on January 1,2012. It has a 9.5% annual coupon and had a 30-year original maturity. (It matures on December 31, 2041.) There is 5 years of call protection (until December 31, 2016), after which lime it can be called at 109that is, at 109% of par, or 1,090. Interest rates have declined since it was issued; and it is now selling at 116.575% of par, or 1,165.75. a. What is the yield to maturity? What is the yield to call? b. If you bought this bond, which return would you actually cant? Explain your reasoning. c. Suppose the bond had been selling at a discount rather than a premium. Would the yield to maturity have been the most likely return, or would the yield to call have been most likely?13PEXPECTED INTEREST RATE Lloyd Corporations 14% coupon rate, semiannual payment. 1,000 par value bonds, which mature in 30 years, are callable 5 years from today at 1,050. They sell at a price of 1,353 54, and the yield curve is flat. Assume that interest rates are expected to remain at their current level. a. What is the best estimate of these bonds' remaining life? b. If Lloyd plans to raise additional capital and wants to use debt financing, what coupon rate would it have to set in order to issue new bonds at par?BOND VALUATION Bond X is noncallable and has 20 years to maturity, a 9% annual coupon, and a 1,000 par value. Your required return on Bund X is 10%; if you buy it, you plan to hold it for 5 years. You (and the market) have expectations that in 5 years, the yield to maturity on a 15-year bond with similar risk will be 85%. How much should you be willing to pay for Bund X today? (Hint: You will need to know how much the bond will be worth at the end of 5 years.)16P17PYIELD TO MATURITY AND YIELD TO CALL Kaufman Enterprises has bonds outstanding with a 1,000 face value and 10 years left until maturity. They have an 11% annual coupon payment, and their current price is 1,175. The bonds may be called in 5 years at 109% of face value (Call price = 1,090). a. What is the yield to maturity? b. What is the yield to call if they are called in 5 years? c. Which yield might investors expect to earn on these bonds? Why? d. The bonds indenture indicates that the call provision gives the firm the right to call the bonds at the end of each year beginning in Year 5. In Year 5, the bonds may be called at 109% of face value; but in each of the next 4 years, the call percentage will decline by 1%. Thus, in Year 6, they may be called at 108% of face value; in Year 7, they may be called at 107% of face value; and so forth. If the yield curve is horizontal and interest rates remain at their current level, when is the latest that investors might expect the firm to call the bonds?BOND VALUATION Clifford Clark is a recent retiree who is interested in investing some of his savings in corporate bonds. His financial planner has suggested the following bonds: Bond A has a 7% annual coupon, matures in 12 years, and has a 1,000 face value. Bond B has a 9% annual coupon, matures in 12 years, and has a 1,000 face value. Bond C has an 11% annual coupon, matures in 12 years, and has a 1,000 face value. Each bond has a yield to maturity of 9%. a. Before calculating the prices of the bonds, indicate whether each bond is trading at a premium, at a discount, or at par. b. Calculate the price of each of the three bonds. c. Calculate the current yield for each of the three bonds. (Hint: Refer to footnote 7 for the definition of the current yield and to Table 7.1.) d. If the yield to maturity for each bond remains at 9%, what will be the price of each bond 1 year from now? What is the expected capital gains yield for each bond? What is the expected total return for each bond? e. Mr. Clark is considering another bond, Bond D. It has an 8% semiannual coupon and a 1,000 face value (i.e., it pays a 40 coupon every 6 months). Bond D is scheduled to mature in 9 years and has a price of 1,150. It is also callable in 5 years at a call price of 1,040. 1. What is the bonds nominal yield to maturity? 2. What is the bonds nominal yield to call? 3. If Mr. Clark were to purchase this bond, would he be more likely to receive the yield to maturity or yield to call? Explain your answer. f. Explain briefly the difference between price risk and reinvestment risk. Which of the following bonds has the most price risk? Which has the most reinvestment risk? A 1-year bond with a 9% annual coupon A 5-year bond with a 9% annual coupon A 5-year bond with a zero coupon A 10-year bond with a 9% annual coupon A 10-year bond with a zero coupon g. Only do this part if you are using a spreadsheet. Calculate the price of each bond (A, B, and C) at the end of each year until maturity, assuming interest rates remain constant. Create a graph showing the time path of each bonds value, similar to that shown in Figure 7.2. 1. What is the expected interest yield for each bond in each year? 2. What is the expected capital gains yield for each bond in each year? 3. What is the total return for each bond in each year?BOND VALUATION Robert Black and Carol Alvarez are vice presidents of Western Money Management and codirectors of the companys pension fund management division A major new client, the California League of Cities, has requested that Western present an investment seminar to the mayors of the represented cities. Black and Alvarez, who will make the presentation, have asked you to help them by answering the following questions. a. What are a bonds key features? b. What are call provisions and sinking fund provisions? Do these provisions make bonds more or less risky? c. How is the value of any asset whose value is based on expected future cash flows determined? d. How is a bonds value determined? What is the value of a 10-year, 1,000 par value bond with a 10% annual coupon if its required return is 10%? e. 1. What is the value of a 13% coupon bond that is otherwise identical to the bond described in part d? Would we now have a discount or a premium bond? 2. What is the value of a 7% coupon bond with these characteristics? Would we now have a discount or premium bond? 3. What would happen to the values of the 7%, 10%, and 13% coupon bonds over time if the required return remained at 10%? (Hint: With a financial calculator, enter PMT, l/YR, FV, and N; then change (override) N to see what happens to the PV as it approaches maturity.) f. 1. What is the yield to maturity on a 10-year, 9% annual coupon, 1,000 par value bond that sells for 887.00? That sells for 1,134.20? What does the fact that it sells at a discount or at a premium tell you about the relationship between rd and the coupon rate? 2. What are the total return, the current yield, and the capital gains yield for the discount bond? Assume that it is held to maturity, and the company docs not default on it. (Hint: Refer to footnote 7 for the definition of the current yield and to Table 7.1.) g. What is price risk? Which has more price risk, an annual payment 1-year bond or a 10-year bond? Why? h. What is reinvestment risk? Which has more reinvestment risk, a 1-year bond or a 10-year bond? i. How does the equation for valuing a bond change if semiannual payments are made? Find the value of a 10-year, semiannual payment, 10% coupon bond if nominal rd = 13%. j. Suppose for 1,000 you could buy a 10%, 10-year, annual payment bond or a 10%, 10-year, semiannual payment bond. They are equally risky. Which would you prefer? If 1,000 is the proper price for the semiannual bond, what is the equilibrium price for the annual payment bond? k. Suppose a 10-year, 10% semiannual coupon bond with a par value of 1,000 is currently selling for 1,135.90, producing a nominal yield to maturity of 8%. However, it can be called after 4 years for 1,050. 1. What is the bonds nominal yield to call (YTC)? 2. If you bought this bond, would you be more likely to cam the YTM or the YTC? Why? l. Does the yield to maturity represent the promised or expected return on the bond? Explain. m. These bonds were rated AA by SP. Would you consider them investment-grade or junk bonds? n. What factors determine a companys bond rating? o. If this firm were to default on the bonds, would the company be immediately liquidated? Would the bondholders be assured of receiving all of their promised payments? Explain. p. q. r. s.Suppose you owned a portfolio consisting of 250,000 of long-term U.S. government bonds. a. Would your portfolio be riskless? Explain. b. Now suppose the portfolio consists of 250,000 of 30-day Treasury bills. Every 30 days your bills mature, and you will reinvest the principal (250,000) in a new batch of bills. You plan to live on the investment income from your portfolio, and you want to maintain a constant standard of living. Is the T-bill portfolio truly riskless? Explain. c. What is the least risky security you can think of? Explain.2Q3QIs it possible to construct a portfolio of foal-world stocks that has a required return equal to the risk-free rate? Explain.Stock A has an expected return of 7%, a standard deviation of expected returns of 35%, a correlation coefficient with the market of - 0.3, and a beta coefficient of -0.5. Stock B has an expected return of 12%, a standard deviation of returns of 10%, a 0.7 correlation with the market, and a beta coefficient of l.0. Which security is riskier? Why?A stock had a 12% return last year, a year when the overall stock market decline. Does this mean that the stock has a negative beta and thus very little risk if held in a portfolio? Explain.If investors aversion to risk increased, would the risk premium on a high-beta stock increase by more or less than that on a low-beta stock? Explain.8QIn Chapter 7, we saw that if the market interest rate, rd, for a given bond increased, the price of the bond would decline. Applying this same logic to stocks, explain (a) how a decrease in risk aversion would affect stocks prices and earned rates of return, (b) how this would affect risk premiums as measured by the historical difference between returns on stocks and returns on bonds, and (c) what the implications of this would be for the use of historical risk premiums when applying the SML equation.1PPORTFOLIO BETA An individual has 35,000 invested in a stock with a beta of 0.8 and another 40,000 invested in a stock with a beta of 1.4. If these are the only two investments in her portfolio, what is her portfolios beta?REQUIRED RATE OF RETURN Assume that the risk-free rate is 6% and the required return on the market is 13%. What is the required rate of return on a stock with a beta of 0.7?EXPECTED AND REQUIRED RATES OF RETURN Assume that the risk-free rate is 5% and the market risk premium is 6%. What is the required return for the overall stock market? What is the required rate of return on a stock with a beta of 1.2?5PEXPECTED RETURNS Stocks X and Y have the following probability distributions of expected future returns: Probability X Y 0.1 (10%) (35%) 0.2 2 0 0.4 12 20 0.2 20 2S 0.1 38 45 a. Calculate the expected rate of return, rY, for Stock Y (rX = 12%). b. Calculate the standard deviation of expected returns, X, for Stock X (Y = 20.35%). Now calculate the coefficient of variation for Stock Y. Is it possible that most investors will regard Stock Y as being less risky than Stock X? Explain.PORTFOLIO REQUIRED RETURN Suppose you are the money manager of a 4 million investment fund. The fund consists of four stocks with the following investments and betas: Stock Investment Beta A 400,000 150 B 600,000 (0.50) C 1,000,000 1.25 D 2,000,000 0.75 If the markets required rate of return is 14% and the risk-free rate is 6%, what is the funds required rate of return?BETA COEFFICIENT Given the following information determine the beta coefficient for Stock J that is consistent with equilibrium: rJ = 12.5%; rRF = 4.5%; rM = 10.5%.REQUIRED RATE OF RETURN Stock R has a beta of 1.5, Stock S has a beta of 0.75, the required return on an average stock is 13%, and the risk-free rate of return is 7%. By how much does the required return on the riskier stock exceed the required return on the less risky stock?10PCAPM AND REQUIRED RETURN Calculate the required rate of return for Manning Enterprises assuming that investors expect a 3.5% rate of inflation in the future. The real risk-free rate is 2.5%, and the market risk premium is 6.5%. Manning has a beta of 1.7, and its realized rate of return has averaged 13.5% over the past 5 years.REQUIRED RATE OF RETURN Suppose rRF = 9%, rM = 14% and bi = 13. a. What is ri, the required rate of return on Stock i? b. Now suppose that rRF (1) increases to 10% or (2) decreases to 8%. The slope of the SML remains constant. How would this affect rM, and ri? c. Now assume that rRF remains at 9% but rM (1) increases to 16% or (2) falls to 13%. The slope of the SML does not remain constant. How would these changes affect ri?CAPM, PORTFOLIO RISK. AND RETURN Consider the following information for Stocks X, Y, and Z. The returns on the three stocks arc positively correlated, but they are not perfectly correlated. (That is, each of the correlation coefficients is between 0 and 1.) Stock Expected Return Standard Deviation Beta X 9.00% 15% 0.8 Y 10.75 15 1.2 Z 12.50 15 1.6 Fund Q has one-third of its funds invested in each of the three stocks. The risk-free rate is 5.5%, and the market is in equilibrium. (That is, required returns equal expected returns.) a. What is the market risk premium (rM rRF)? b. What is the beta of Fund Q? c. What is the required return of Fund Q? d. Would you expect the standard deviation of Fund Q to be less than 15%, equal to 15%, or greater than 15%? Explain.14PCAPM AND REQUIRED RETURN HR Industries (HRI) has a beta of 1.8, while LR Industries (LRI) beta is 0.6. The risk-free rate is 6%, and the required rate of return on an average stock is 13%. The expected rate of inflation built into rRF falls by 1.5 percentage points, the real risk-free rate remains constant, the required return on the market falls to 10.5%, and all betas remain constant. After all of these changes, what will be the difference in the required returns for HRI and LRI?CAPM AND PORTFOLIO RETURN You have been managing a 5 million portfolio that has a beta of 1.25 and a required rate of return of 12%. The current risk-free rate is 5.25%. Assume that you receive another 500,000. If you invest the money in a stock with a beta of 0.75, what will be the required return on your 5.5 million portfolio?PORTFOLIO BETA A mutual fund manager has a 20 million portfolio with a beta of 1.5. The risk-free rate is 4.5%, and the market risk premium is 5.5%. The manager expects to receive an additional 5 million, which she plans to invest in a number of stocks. After investing the additional funds, she wants the funds required return to be 13%. What should be the average beta of the new stocks added to the portfolio?EXPECTED RETURNS Suppose you won the lottery and had two options: (1) receiving 0.5 million or (2) taking a gamble in which, at the flip of a coin, you receive 1 million if a head comes up but receive zero if a tail comes up. a. What is the expected value of the gamble? b. Would you take the sure 0.5 million or the gamble? c. If you chose the sure 0.5 million, would that indicate that you are a risk averter or a risk seeker? d. Suppose the payoff was actually 0.5 million that was the only choice. You now face the choice of investing it in a U.S. Treasury bond that will return 537,500 at the end of a year or a common stock that has a 50-50 chance of being worthless or worth 1,150,000 at the end of the year. l. The expected profit on the T-bond investment is 37,500. What is the expected dollar profit on the stock investment? 2. The expected rate of return on the T-bond investment is 7.5%. What is the expected rate of return on the stock investment? 3. Would you invest in the bond or the stock? Why? 4. Exactly how large would the expected profit (or the expected rate of return) have to be on the stock investment to make you invest in the stock, given the 7.5% return on the bond? 5. How might your decision be affected if, rather than buying one stock for 0.5 million, you could construct a portfolio consisting of 100 stocks with 5,000 invested in each? Each of these stocks has the same return characteristics as the one stock that is, a 50-50 chance of being worth zero or 11,300 at year-end. Would the correlation between returns on these stocks matter? Explain.EVALUATING RISK AND RETURN Stock X has a 10% expected return, a beta coefficient of 0.9, and a 35% standard deviation of expected returns. Stock Y has a 12.5% expected return, a beta coefficient of 1.2, and a 25% standard deviation. The risk-free rate is 6%, and the market risk premium is 5%. a. Calculate each stocks coefficient of variation. b. Which stock is riskier for a diversified investor? c. Calculate each stocks required rate of return. d. On the basis of the two stocks expected and required returns, which stock would be more attractive to a diversified investor? e. Calculate the required return of a portfolio that has 7,500 invested in Stock X and 2,500 invested in Stock Y. f. If the market risk premium increased to 6%, which of the two stocks would have the larger increase in its required return?20PSECURITY MARKET LINE You plan to invest in the Kish Hedge Fund, which has total capital of 500 million invested in five stocks: Stock Investment Stocks Beta Coefficient A 160 million 0.5 B 120 million 1.2 C 80 million 1.8 D 80 million 1.0 E 60 million 1.6 Kishs beta coefficient can be found as a weighted average of its stocks betas. The risk-free rate is 6%, and you believe the following probability distribution for future market returns is realistic: Probability Market Return 0.l -28% 0.2 0 0.4 12 0.2 30 0.1 50 a. What is the equation for the security market line (SML)? (Hint First, determine the expected market return.) b. Calculate Kishs required rate of return. c. Suppose Rick Kish, the president, receives a proposal from a company seeking new capital. The amount needed to lake a position in the stock is 50 million, it has an expected return of 15%, and its estimated beta is 1.5. Should Kish invest in the new company? At what expected rate of return should Kish be indifferent to purchasing the stock?22SP23IC1DQ2DQ3DQSelect one of the four stocks listed in Question 3 by entering the companys ticker symbol on the financial website you have chosen. On the screen you should see the interactive chart. Select the six-month time period and select the SP 500, so the stocks performance will be compared to the SP 500s performance on the graph. Has the stock outperformed or underperformed the overall market during this time period?Go back to the summary page to see an estimate of the companys beta. What is the companys beta? What was the source of the estimated beta? Realize that if you go to another website, the beta shown could be different due to measurement differences.6DQ7DQBeta pf CPB company Beta of the MSI Company is 0.19. The beta of TIF Company is 1.76. Repeat the same exercise for each of the three remaining companies. Do the reported betas confirm your earlier intuition? In general, do you find that the higher-beta stocks tend to do better in up markets and worse in down markets? Explain.It is frequently stated that the one purpose of the preemptive right is to allow individuals to maintain their proportionate share of the ownership and control of a corporation. a. How important do you suppose control is for the average stockholder of a firm whose shares are traded on the New York Stock Exchange? b. Is the control issue likely to be of more importance to stockholders of publicly owned or closely held (private) firms? Explain.Is the following equation correct for finding the value of a constant growth stock? Explain. P0=Dors+g3QTwo investors are evaluating GEs stock for possible purchase. They agree on the expected value of D1 and on the expected future dividend growth rate. Further, they agree on the riskiness of the stock. However, one investor normally holds stocks for 2 years, while the other holds stocks for 10 years. On the basis of the type of analysis done in this chapter, should they both be willing to pay the same price for GEs stock? Explain.A bond that pays interest forever and has no maturity is a perpetual bond. In what respect is a perpetual bond similar to a no-growth common stock? Are there preferred stocks that are evaluated similarly to perpetual bonds and other preferred issues that are more like bonds with finite lives? Explain.Discuss the similarities and differences between the discounted dividend and corporate valuation models.This chapter discusses the discounted dividend and corporate valuation models for valuing common stocks. Two alternative approaches, the P/E multiple and EVA approaches, were presented. Explain each approach and how you might use each one to value a common stock.1P2P3PNONCONSTANT GROWTH VALUATION Hart Enterprises recently paid a dividend, D0, of 1.25. It expects to have nonconstant growth of 20% for 2 years followed by a constant rate of 5% thereafter. The firms required return is 10%. a. How far away is the horizon date? b. What is the firms horizon, or continuing, value? c. What is the firms intrinsic value today, P0?CORPORATE VALUATION Smith Technologies is expected to generate 150 million in free cash flow next year, and FCF is expected to grow at a constant rate of 5% per year indefinitely. Smith has no debt or preferred stock, and its WACC is 10%. If Smith has 50 million shares of stock outstanding, what is the stocks value per share?PREFERRED STOCK VALUATION Fee Founders has perpetual preferred stock outstanding that sells for 60 a share and pays a dividend of 5 at the end of each year. What is the required rate of return?7P8PPREFERRED STOCK RETURNS Bruner Aeronautics has perpetual preferred stock outstanding with a par value of 100. The stock pays a quarterly dividend of 2, and its current price is 80. a. What is its nominal annual rate of return? b. What is its effective annual rate of return?VALUATION OF A DECLINING GROWTH STOCK Martell Mining Companys ore reserves are being depleted, so its sales are falling. Also, because its pit is getting deeper each year, its costs are rising. As a result, the companys earnings and dividends are declining at the constant rate of 5% per year. If D0 = 85 and rs = 15%, what is the value of Martell Minings stock?VALUATION Of A CONSTANT GROWTH STOCK A stock is expected to pay a dividend of 0.50 at the end of the year (that is, D1 = 0.50). and it should continue to grow at a constant rate of 7% a year. If its required return is 12%. what is the stocks expected price 4 years from today?12PCONSTANT GROWTH You are considering an investment in Keller Corporations stock, which is expected to pay a dividend of 52.00 a share at the end of the year (D1 = 2.00) and has a beta of 0.9. The risk-free rate is 5.6%, and the market risk premium is 6%. Keller currently sells for 25.00 a share, and its dividend is expected to grow at some constant rate g. Assuming the market is in equilibrium, what does the market believe will be the stock price at the end of 3 years? (That is. what is P3?)NONCONSTANT GROWTH Microtech Corporation is expanding rapidly and currently needs to retain all of its earnings; hence, it does not pay dividends. However, investors expect Microtech to begin paying dividends, beginning with a dividend of 1.00 coming 3 years from today. The dividend should grow rapidlyat a rate of 50% per yearduring Years 4 and 5; but after Year 5, growth should be a constant 8% per year. If the required return on Microtech is 15%. what is the value of the stock today?CORPORATE VALUATION Dozier Corporation is a fast-growing supplier of office products. Analysts project the following free cash flows (FCFs) during the next 3 years, after which PCF is expected to grow at a constant 7% rate. Doziers WACC is 13%. a. What is Doziers horizon, or continuing, value? (Hint: Find the value of all free cash flows beyond Year 3 discounted back to Year 3.) b. What is the firms value today? c. Suppose Dozier has 100 million of debt and 10 million shares of stock outstanding. What is your estimate of the current price per share?16PCONSTANT GROWTH Your broker offers to sell you some shares of Bahnsen Co. common stock that paid a dividend of 2.00 yesterday. Bahnsens dividend is expected to grow at 5% per year for the next 3 years. If you buy the stock, you plan to hold it for 3 years and then sell it. The appropriate discount rate is 12%. a. Find the expected dividend for each of the next 3 years; that is, calculate D1, D2, and D3. Note that D0 = 2.00. b. Given that the first dividend payment will occur 1 year from now, find the present value of the dividend stream; that is, calculate the PVs of D1, D2, and D3, and then sum these PVs. c. You expect the price of the stock 3 years from now to be 34.73; that is, you expect P3 to equal 34.73. Discounted at a 12% rate, what is the present value of this expected future stock price? In other words, calculate the PV of 34.73. d. If you plan to buy the stock, hold it for 3 years, and then sell it for 34.73, what is the most you should pay for it today? e. Use Equation 9.2 to calculate the present value of this stock. Assume that g = 5% and that it is constant. f. Is the value of this stock dependent upon how long you plan to hold it? In other words, if your planned holding period was 2 years or 5 years rather than 3 years, would this affect the value of the stock today, P0? Explain.NONCONSTANT GROWTH STOCK VALUATION Taussig Technologies Corporation (TTC) has been growing at a rate of 20% per year in recent years. This same growth rate is expected to last for another 2 years, then decline to gn =6%. a. If D0 = 1.60 and rs = 10%, what is TICs stock worth today? What are its expected dividend, and capital gains yields at this time, that is, during Year 1? b. Now assume that ITCs period of supernormal growth is to last for 5 years rather than 2 years. Flow would this affect the price, dividend yield, and capital gains yield? Answer in words only. c. What will TTCs dividend and capital gains yields be once its period of supernormal growth ends? (Hint: These values will be the same regardless of whether you examine the case of 2 or 5 years of supernormal growth; the calculations are very easy.) d. Explain why investors are interested in the changing relationship between dividend and capital gains yields over time.19PCORPORATE VALUE MODEL Assume that today is December 31, 2014, and that the following information applies to Vermeil Airlines: After-tax operating income [EBIT(1 T)] for 2015 is expected to be 500 million. The depreciation expense for 2015 is expected to be 100 million. The capital expenditures for 2015 are expected to be 200 million. No change is expected in net operating working capital. The free cash flow is expected to grow at a constant rate of 6% per year.NONCONSTANT GROWTH Assume that it is now January 1, 2015. Wayne-Martin Electric Inc. (WME) has developed a solar panel capable of generating 200% more electricity than any other solar panel currently on the market. As a result, WME is expected to experience a 15% annual growth rate for the next 5 years. Other firms will have developed comparable technology at the end of 5 years, and WMEs growth rate will slow to 5% per year indefinitely. Stockholders require a return of 12% on WMEs stock. The most recent annual dividend (D0), which was paid yesterday, was 1.75 per share. a. Calculate WMEs expected dividends for 2015, 2016, 2017, 2018, and 2019. b. Calculate the value of the stock today, P0. Proceed by finding the present value of the dividends expected at the end of 2015, 2016, 2017, 2018, and 2019 plus the present value of the stock price that should exist at the end of 2019. The year-end 2019 stock price can be found by using the constant growth equation. Notice that to find the December 31, 2019, price, you must use the dividend expected in 2020, which is 5% greater than the 2019 dividend. c. Calculate the expected dividend yield (D1/P0), capital gains yield, and total return (dividend yield plus capital gains yield) expected for 2015. (Assume that P0 = P0 and recognize that the capital gains yield is equal to the total return minus the dividend yield.) Then calculate these same three yields for 2020. d. How might an investors tax situation affect his or her decision to purchase stocks of companies in the early stages of their lives, when they are growing rapidly, versus stocks of older, more mature firms? When docs WMEs stock become mature for purposes of this question? e. Suppose your boss tells you she believes that WMEs annual growth rate will be only 12% during the next 5 years and that the firms long-run growth rate will be only 4%. Without doing any calculations, what general effect would these growth rate changes have on the price of WMLs stock? f. Suppose your boss also tells you that she regards WML as being quite risky and that she believes the required rate of return should be 14%, not 12%. Without doing any calculations, determine how the higher required rate of return would affect the price of the stock, the capital gains yield, and the dividend yield. Again, assume that the long-run growth rate is 4%.Comprehensive/Spreadsheet Problem NONCONSTANT GROWTH AND CORPORATE VALUATION Rework problem 9-18, parts a, b, and c, using a spreadsheet model. For part b, calculate the price, dividend yield, and capital gains yield as called for In the problem. After completing parts a through c, answer the following additional question, using the spreadsheet model. d. TTC recently introduced a new line of products that has been wildly successful. On the basis of this success and anticipated future success, the following free cash flows were projected: After the tenth year, TTCs financial planners anticipate that its free cash flow will grow at a constant rate of 6%. Also, the firm concluded that the new product caused the WACC to fall to 9%. The market value of TTCs debt is 1,200 million; it uses no preferred stock; and there are 20 million shares of common stock outstanding. Use the corporate valuation model to value the stock. NONCONSTANT GROWTH STOCK VALUATION Taussig Technologies Corporation (TTC) has been growing at a rate of 20% per year in recent years. This same growth rate is expected to last for another 2 years, then decline to gn =6%. a. If D0 = 1.60 and rs = 10%, what is TICs stock worth today? What are its expected dividend, and capital gains yields at this time, that is, during Year 1? b. Now assume that ITCs period of supernormal growth is to last for 5 years rather than 2 years. Flow would this affect the price, dividend yield, and capital gains yield? Answer in words only. c. What will TTCs dividend and capital gains yields be once its period of supernormal growth ends? (Hint: These values will be the same regardless of whether you examine the case of 2 or 5 years of supernormal growth; the calculations are very easy.) d. Explain why investors are interested in the changing relationship between dividend and capital gains yields over time.MUTUAL Of CHICAGO INSURANCE COMPANY 9-23 STOCK VALUATION Retort Balik and Carol Kiefer we senior vice presidents of the Mutual of Chicago Insurance Company. They are co-directors of the companys pension fund management division, with Balik having responsibility for fixed-income securities (primarily bonds) and Kiefer being responsible for equity investments. A major new client, the California League of Cities, has requested that Mutual of Chicago present an investment seminar to the mayors of the represented cities, and Balik and Kiefer, who will make the actual presentation, have asked you to help them. To illustrate the common stock valuation process, Balik and Kiefer have asked you to analyze the Bon Temps Company, an employment agency that supplies word-processor operators and computer programmers to businesses with temporarily heavy workloads. You are to answer the following questions: a. Describe briefly the legal rights and privileges of common stockholders. 1. Write a formula that can to used to value any stock, regardless of its dividend pattern. 2. What is a constant growth stock How are constant growth stocks valued? 3. What air the implications if a company forecasts a constant g that exceeds its rs? Will many stocks have expected g rs in the short run (that is, for the next few years)? In the long run (that is, forever)? b. Assume that Bon Temps has a beta coefficient of 1.2, that the risk-free rate (the yield on T-bonds) is 7%, and that the required rate of return on the market is 12%. What is Bon Temps required rate of return? c. Assume that Bon Temps is a constant growth company whose last dividend (D0, which was paid yesterday) was 2.00 and whose dividend is expected to grow indefinitely at a 6% rate. 1. What is the firms expected dividend stream over the next 3 years? 2. What is its current stock price? 3. What is the stocks expected value 1 year from now? 4. What are the expected dividend yield, capital gains yield, and total return during the first year? d. Now assume that the stock is currently selling at 30.29. What is its expected rate of return? e. What would the stock price to if its dividends were expected to have zero growth? f. Now assume But Bon Temps is expected to experience nonconstant growth of 30% for the next 3 years, then return to its long-run constant growth rate of 6%. What is the stocks value under these conditions? What are its expected dividend and capital gains yields in Year 1? Year 4? g. Suppose Bon Temps expected to experience zero growth during the first 3 years and then resume its steady-state growth of 6% in the fourth year. What would be its value then?. What would to its expected dividend and capital gains yields in Year 1 In Year 4? h. Finally, assume that Bon Tempss comings and dividends are expected to decline at a constant rate of 6% per year, that is, g = 6%. Why would anyone be willing to buy such a stock, and at what price should it sell? What would to its dividend and capital gains yields in each year? i. Suppose Bon Temps embarked on an aggressive expansion that requires additional capital Management decided to finance the expansion by borrowing 40 million and by halting dividend payments to increase retained earnings. Its WACC is now 10%, and the protected free cash flows for the next 3 years are 5 million, 10 million. and 20 million. After Year 3, free cash flow is protected to grow at a constant 6%. What is Bon Tempss total value? If it has 10 million shares of stock and 40 million of debt and preferred stock combined, w hat is the price per share? j. Suppose Bon Temps decided to issue preferred stock that would pay an annual dividend of 500 and that the issue price was 50.00 per share What would be the stocks expected return? Would the expected rate of return he the same if the preffered was a perpetual issue or if it had a 20-year1DQ2DQ3DQ4DQ5DQ6DQThe required return on equity, rs, is the final input needed to estimate intrinsic value. For our purposes, you can assume a number (say, 9% or 10%) or you can use the CAPM to calculate an estimate of the cost of equity, using the data available on the Internet (For more details, look at the Taking a Closer Look exercise for Chapter 8.) Having decided on your best estimates for D1, rs, and g, you can calculate XOMs intrinsic value. Be careful to make sure that the long-run growth rate is less than the required rate of return. How does this estimate compare with the current stock price? Does your preliminary analysis suggest that XOM is undervalued or overvalued? Explain.8DQ9DQ10DQFor a stock to be in equilibrium, what two conditions must hold?If a stock is not in equilibrium, explain how financial markets adjust to bring it into equilibrium.RATES OF RETURN AND EQUILIBRIUM Stock Cs beta coefficient is bC = 0.4, and Stock Ds is bD = 0.5. (Stock Ds beta is negative, indicating that its return rises when returns on most other stocks fall. There are very few negative beta stocks, although collection agency stocks are sometimes cited as an example.) a. If the risk-free rate is 7% and the required rate of return on an average stock is 11%, what are the required rates of return on Stocks C and D? b. For Stock C, suppose the current price, P0, is 25.00; the next expected dividend, D1 is 1.50; and the stocks expected constant growth rate is 4%. Is the stock in equilibrium? Explain and describe what will happen if the stock is not in equilibrium.